Guest blog by Charlotte Hall
Mental accounting is used subconsciously by individuals to organise resources, evaluate financial activities and make consumption decisions. Research suggests ‘mental accounting’ can cause poor judgement and irrational thought processes, but what is it?
“Mental accounting is a term that refers to a behavioural bias that can lead to less than optimal financial decisions. Mental accounting involves the separation of potential economic outcomes into separate and often arbitrary mental accounts.”1.
Research suggests people have “mental accounts” in mind in every economic decision and prefer their gains to be segregated (or set aside) and their losses to be integrated (or hidden). Consequently rather than treating each unit of money as if it were exactly the same, people assign it into what they need and what they do not need. This ultimately can mean financial amounts with the same monetary value are categorised separately and sometimes irrationally.
Another aspect of mental accounting is that people treat financial gains differently depending on its source. Individuals tend to spend a lot more “found” money, such as tax refunds, unexpected winnings and gifts, compared to a similar amount of money that is normally expected, such as from their wages. This represents another instance of how mental accounting can cause illogical use of money and expensive mistakes.
Unfortunately many individuals and businesses are unwittingly affected by mental accounting, as illustrated by the following scenarios:
- Segregating balances – Having a positive £20,000 in the bank, with a savings rate of 1.5%, but a company credit card at £20,000 with an interest rate of 15%.
- Expense interpretation – Negotiating asset costs of £5,000 but spending an additional £5,000 on delivery.
- Unexpected financial returns – Receiving a tax refund of £2,000 and spending impulsively, but wisely reinvesting £2,000 of expected income.
- Identical purchases – Confusing materially identical purchases because of different environments and influences.
Mental accounting is problematic, but it can be beaten. The following steps can be taken to overcome dilemmas and invest wisely:
- Treat all income as earned income.
- Detailed record keeping & planning – Internal controls and understanding the little things add up are key philosophy to successful expenditure.
- Consider material acquisitions as a whole rather than separating them into small purchases.
Resources
1. Annuity Digest ‘Mental Accounting’ [[Online]] http://www.annuitydigest.com/mental-accounting/definition Accessed: 17/03/2015